Finance

-
M
oney is an arm or a leg. You can either use it
or lose it._ Henry Ford
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T
he Sanskrit saying “arthahsachivah” means
finance reigns supreme.
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R
eady money is Alladin’ lamp._Byron
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Meaning of finance
¤
Finance is the management of the monetary
affairs of a company. ____ Paul G Hasings
¤
Financing is the process of organizing the flow
of funds so that a business firm can carry out
its objectives in the most efficient manner and
meet its obligations as they fall due. __Ronald
¤
Finance is the common denominator for a vast
range of corporate objectives, and the major
part of any corporate plan must be expressed
in financial terms. ____________ALKignshott
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-Finance means to arrange payment for it. __George
Christy and Peter Rodan
-The act of providing the means of payment.
__Encyclopaedia Britannica
In nutshell finance is closely linked with the flow of
money, the availability of funds at a time, advance
knowledge of, or information about financial
commitments etc. The focus of finance is on the flow of
funds which is justifiable, because the financial
manager must take financial decisions based on mainly
flow of funds.
Financial management
¤ Financial management is an applied branch of general
management that looks after the finance function of a
business. Management in general deals with effective
procurement and utilization of basic inputs like men,
machines, methods, materials and markets, and money
or finance is a common thread that passes through the
wide-spectrum of all business activities; and
management of finance is a key variable that determines
the success or failure of any business activity.
¤ Financial management is a dynamic subject and is
responsible for operating a business efficiently and
effectively. Traditionally the subject of financial
management was considered only in narrow sense but
the modern concept of financial management has very
wide coverage. It has to bring compatibility between
conflicting goals of liquidity and profitability.
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¤
Financial management, however, should not be
taken to be a profit-extracting device. No doubt
finances have to be so planned as to contribute to
profit-making activities within an organization, as
finance cannot be generated without profits. But
there is much more. Financial management implies
a more comprehensive concept than the simple
objective of profit making or efficiency.
¤
Its broader mission is to maximize the value of the
firm so that interests of different sections of
society remain undisturbed and protected.
¤
Financial management is an integrated and
composite subject. It welds together substantial
material that is found in accounting, economics,
mathematics, systems analysis and behavioral
sciences and uses other disciplines as its tool.
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×
“Financial management deals with how the
corporation obtains the funds and how it uses
them”.--- Hoagland
×
“The term financial management refers to the
application of skills in the manipulation, use and
control of funds”.--- Mock, Schultz and Shuckett
×
“Financial management is the custodian of corporate
funds. It has to plan, organise and control the
finances of the enterprise”. ---S A Sherlekar
×
It can be concluded by saying that financial
management is not only concerned with procurement
of funds but it also deals with three decision-making
areas called investment decisions, financing decisions
and dividend decisions.
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Financial management emerged as a distinct field
of study at the turn of 20
th
century. Its evolution
can be divided into three broad phases( though
the demarcating lines between these phases are
somewhat arbitrary)__the traditional phase, the
transitional phase, and the modern phase.

Traditional Phase
The traditional phase lasted for about four decades.
Following were its important features:
1)The focus of financial management was mainly on certain
episodic events like formation, issuance of capital, major
expansion, merger, reorganization and liquidation in the
lifecycle of the firm.
2)The approach was mainly descriptive and institutional.
3)The approach placed great emphasis on long term problems.
4)The outsider’s like investment bankers, lenders and other
outside interest point of view was dominant.
5) Financial management was not considered to be a
managerial function.
A typical work of the traditional phase is The Financial Policy Of
Corporations by Arthur S Dewing.
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Transitional Phase

The Transitional Phase began around the early
1940s and continued through the early 1950s. Though
the nature of financial management during was similar
to that of the traditional phase, greater was placed on
the day-to-day problems faced by financial managers in
the areas of funds analysis, planning and control. The
focus shifted to Working Capital Management.
A representative work of this phase is Essays On
Business Finance by Wilford J. Eitman et al.
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Modern Phase
The Modern Phase began in mid 1950s and has
witnessed an accelerated pace of development with the
infusion of ideas from economic theory and application of
quantitative methods of analysis. The distinctive features
of the modern phase are:
1) The central concern of financial management is
considered to be a rational matching of funds to their uses
so as to maximize the wealth of the shareholders.
2) The approach of financial management has become
more analytical.
3) It covers security markets and studies security analysis
and portfolio management.
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4) It covers fund management of government, profitable
and non-profitable social oriented institutions like
educational institutions, hospitals clubs and NGOs.
5) It provides coverage to international fund flow
management, foreign exchange and risk management.
6) Finance has assumed the position of a managerial
function and is no longer an outsider looking approach. It
deals with three decision-making areas called
investment decisions, financing decisions and dividend
decisions.
7) Modern financial management covers various tools
and techniques of evaluation, important being, funds
flow analysis, cash flow analysis, capital budgeting, cost
of capital, leverages, working capital management, eva,
mva and capm etc.
Scope Of Financial Management
-
As already discussed the scope of financial
management has increased manifold i.e. from simply
raising of funds to investment decisions, financing
decisions and dividend decisions.
-
The scope of financial management may broadly be
classified into five A’s viz.
1)Anticipation of the financial needs of the
organization;
2)Acquisition of the necessary capital and
determining the sources of finance;
3)Allocation of funds which with the deployment of
total funds between the different components of fixed
and current assets;
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4) Appropriation which basically considers the
division of total earnings between the dividend
distribution and retention of profits in the business
and
5)Assessment which deals with the control over
financial activities.
Objectives of Financial Management
×
Basic Objectives
×
Other Objectives
Basic Objectives:
1) Profit Maximisation
2) Wealth Maximisation
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Profit Maximization
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Profit maximisation implies that a firm either produces
maximum output for a given amount of input, or uses
minimum input for producing a given output. Profit
earning is the main aim of every business activity.
-
A business being an economic institution must earn
profit to cover its costs and provide funds for growth.
Profit is the measure of efficiency. Profits provide
protection against risks. Accumulated profits help an
organization to face market oscillations. Thus profit
maximisation is considered to be the main objective of
a business enterprise .Profit is considered as the most
appropriate measure of a firm’s performance.
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Points in favour of Profit
maximisation.
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Profit is a barometer through which the
performance of a business unit can be gauged.
-
Profit ensures maximum welfare of all the
stakeholders.
-
Profit maximisation increases the confidence of
management for modernization, expansion and
diversification.
-
Profit maximisation attracts the investors to
invest.
-
Profits indicate efficient utilization of funds.
-
Profits ensure survival during adverse business
conditions.




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Points Against Profit
Maximisation
¤
It may encourage corrupt and unethical practices.
¤
It ignores time value of money.
¤
It does not take into account the element of risk.
¤
It attracts cut throat competition.
¤
Huge amount of profit may attract Government
intervention.
¤
Huge profits may invite problems from workers
who may demand increased wages and salaries.
¤
Customers may feel exploited.
¤
Profit maximisation may adversely affect the long
term liquidity position of the company.
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¤
The term profit is vague and it cannot be
defined precisely.
¤
The effect of dividend policy on the market
price of shares is not considered.
¤
All said and done there is no denying the
fact that no organization can ignore the
aspect of profit. The point to be taken care of
is that it is earned following ethical practices.
The interests of all the stakeholders should
be kept in mind. The point of view of the
society at large should not be ignored.
Wealth Maximisation
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The goals of the management should be such all the
stakeholders are benefitted. A financial action that has a
positive NPV creates wealth for shareholders and, therefore,
is desirable. Between mutually exclusive projects the one
with the highest NPV should be adopted. This is referred to
as the principle of value additivity. The wealth will be
maximized if NPV criteria is followed in making financial
decisions.
-
The objective of wealth maximisation takes care of the
questions of the timing and risk of the expected benefits. It
is important to emphasize that benefits are measured in
terms of cash flows. In investment and financing decisions, it
is the flow of cash that is important, not the accounting
profits.
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Elements Of Wealth
Maximisation
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Increase in profits
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Reduction in costs
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Judicious choice regarding sources of funds
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Minimum risk
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Long term value
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Points in Favour of Wealth
Maximisation
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As the net present value of cash flows is
considered, the net effect of investments and
benefits can be measured in quantitative terms.
¤
It considers the concept of time value of money.
The present values of cash inflows and outflows
helps the management to achieve the overall
objective of the company.
¤
It takes care of the interests of all the
stakeholders.
¤
It guides the management in formulating a
consistent dividend policy.
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¤
It considers the impact of risk factor and while
calculating the NPV at a particular discount rate,
adjustment is made to cover the risk that is
associated with investments.
¤
It implies long run survival and growth of the firm.
¤
It leads to maximizing stockholders’ utility or
value maximisation of equity shareholders
through increase in stock price per share.
Point Against Wealth
Maximisation
¤
It may not be socially desirable.
¤
There is some confusion as to whether the objective
is to maximize stockholders’ wealth or the wealth of
the firm , the latter includes other financial
claimholders also such as debenture holders and
preference shareholders etc.
¤
Because of divorce between ownership and
management, the latter may be more interested in
maximizing managerial utility than shareholders
wealth.

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Risk Return Trade Off
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Financial decisions incur different degrees of risk.
Financial decisions of a firm are guided by the risk
return trade-off. These decisions are interrelated and
jointly affect the market value of its shares by
influencing return and risk of the firm. The relationship
between return and risk can be expressed as follows:
Return= Risk free rate+Risk premium
-
Risk free rate is a rate obtainable from a default-free
Government security. Risk free rate is a compensation
for time and risk premium for risk. Higher the risk of an
action, higher will be the risk premium leading to
higher required return on that action. A proper balance
between return and risk should be maintained.
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-To maximize the market value of a firm’s shares. Such
balance is called risk-return trade-off, and every
financial decision involves this trade off.
-The financial manager , in a bid to maximize
shareholders’ wealth, should strive to maximize returns
in relation to the given risk; he or she should seek
courses of actions that avoid unnecessary risks. To
ensure maximum return, funds flowing in and out of the
firm should be constantly monitored to ensure that they
are safeguarded and properly utilized. The financial
reporting system must be designed to provide timely
and accurate picture of the firm’s activities.

¤
All said and done, both the basic objectives
of financial management are important,
though in the present day set up , wealth
maximisation has emerged to be the
premier.
¤
There is no harm in maximizing the profits,
if they are earned in a fair, just, transparent
and judicious manner. Profits earned by
resorting to unethical, corrupt and
undesirable practices are not welcome.
Profits earned in a fair manner will certainly
lead to the achievement of ultimate object
of financial management.
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Other Objectives
+
Ensuring a fair return to shareholders
+
Building up reserves for growth and expansion
+
Ensuring maximum operational efficiency by
efficient and effective utilization of finances.
+
Ensuring financial discipline in the
organization
+
Maintenance of liquid assets
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Capital Budgeting
Capital budgeting is the process of making investment decisions in
capital expenditure. When huge funds are to be committed for a
fairly long period of time, various alternative proposals may be
available. Putting/Ranking such proposals in order of merit or priority
is called capital budgeting. Utmost care has to be exercised at this
stage because reversing such a decision is a very costly affair.
Capital budgeting refers to the planned and pre-decided allocation of
funds available to the firm to long term assets so as to achieve the
maximum from these resources.
‘Capital budgeting, then, consists in planning the deployment of
available capital for the purpose of maximizing the long term
profitability(return on investment) of the firm’.---- R M Lynch
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- ‘Capital budgeting involves a current investment in which
the benefits are expected to be received beyond one
year in future’.--- Van Horne
- ‘The capital budgeting decision, therefore, involves
current outlay or series of outlays of cash resources in
return for an anticipated flow of future benefits’.
----G D Quirin
- ‘Capital budgeting refers to the total process of
generating, evaluating, selecting and following up on
capital expenditure alternatives’.--- Lawrence J Gitman
- ‘Capital budgeting is a long term planning for making and
financing proposed capital outlays’.---Horngreen

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Capital Expenditure
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A capital expenditure may be defined as an
expenditure the benefit of which are expected
to be received over period of time exceeding
one year. For e.g.
¤
Cost of acquisition of permanent asset as
land and building, plant and machinery etc.
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Cost of addition, expansion, improvement or
alteration of permanent asset.
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Cost of replacement of permanent asset.
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Research and development project costs etc.
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Need and importance of Capital
Budgeting
Capital budgeting, or in other words, making decisions
regarding heavy investment in fixed assets sunk for a long
time, is of utmost importance. ‘A keen watchfulness and a
positive awareness of capital expenditure needs,’ states J.
Batty , is essential at all times
The importance, near indispensability and necessity of
having a systematic budgeting for capital expenditure is on
account of the following factors:
1.Huge investment of funds
2.Long term commitment of funds
3.Reversal causes huge losses
4.Factor of obsolescence
5.Loss of flexibility
6.Essential for various decisions and forecasts
7.Impact on future cost structure
8.National importance
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Capital Budgeting
Process
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Identification of Investment Proposals
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Screening the Proposal
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Evaluation of Various Proposals
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Fixing Priorities
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Final Approval and Presentation of Capital
Expenditure Budget
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Implementing Proposal
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Performance Review
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Project formulation is one of the basic
techniques through which planning can
change from an intuitive base to an
institutional and rational base.
G. Myrdal
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Stages/Process of Project
formulation
1) Project identification
2) Technical analysis
a) Input Analysis
¤
b) Demand and Supply analysis
(i) Location (ii) Size and cost of land
(iii) Raw materials (iv) Utilities
(v) Manpower (vi) Transport facilities
(vii) Incentives and
concessions
(viii) Environmental
considerations
(ix) Climatic and natural
hazard considerations
(x) Technological aspects
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¤
3) Economic analysis
(a) Capital cost
(b) Working capital requirements
(c) estimates of operating costs
(d) estimates of operating revenues
(e) Depreciation/Taxes &
(f) Profits
4) Financial analysis
a)Financial analysis based on
commercial
profitability
(b) Financial analysis based on cost-
benefit
profitability

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(i) Simple rate of return (ii) Pay back period
(iii) Net present value (iv) IRR
(v) Financial ratios (vi) Cash flow statement
(i) Break even analysis
(ii) Sensitivity analysis
(iii) Risk analysis
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(i) Technical (ii) Economic
(iii) Financial (iv) Commercial
(v) Organizational (vi) Managerial
(vii) Social (viii) Environmental
Project Selection
-
Those projects which have been found
feasible have to pass through another test.
These have to be ranked from the point of
view of two points:
1.Liquidity- which refers to time factor,
employing the period of recovery of the
investment.
2.Profitability- which hints at the rate of return
on the investment into capital projects.
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Different main methods of
ranking capital investment
proposals:
1. Urgency
2. Pay-back method
3. Average rate of return
4. Discounted cash flow techniques
These methods, along with their variations
will be discussed in the matter to follow.
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Methods of Capital
budgeting
¤
Traditional Methods
¤
Pay-back period
Method
¤
Improvement of
traditional approach
to pay-back period
Method
¤
Rate of Return
Method
¤
Time-adjusted
Methods
¤
Net Present Value
Method
¤
Internal Rate of
Return Method
¤
Profitability Index
Method
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Factors Influencing Capital
Expenditure Decisions
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Urgency
¤
Degree of Certainty
¤
Legal factors
¤
Intangible Factors
¤
Availability of Funds
¤
Future Earnings
¤
Research and Development Projects
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Capital Rationing
-
Capital rationing means distribution of capital in
favour of more acceptable proposals. It refers to a
situation where the firm is constrained for external,
or self imposed, reasons to obtain necessary funds
to invest in all investment projects with positive
NPV. Under capital rationing, the management has
not simply to determine the profitable investment
opportunities, but it has also to decide to obtain
that combination of the profitable projects which
yield highest NPV within the available funds. There
are two types of capital rationing:
-
1)External capital rationing
-
2)Internal capital rationing
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¤
In a study of Indian companies it has been
revealed that most companies do not reject
projects on account of capital shortage.
They face the problem of shortage of funds
due to the management’s desire to limit
capital expenditures to internally generated
funds or the reluctance to raise capital from
outside. In most of companies the bases to
choose projects under capital rationing are:
¤
Profitability;
¤
Priorities set by management;
¤
Experience
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¤
Some companies satisfy the criteria of
profitability and strategic considerations for
allocating limited funds.
¤
Generally companies do not reject profitable
projects under capital rationing; they
postpone till funds become available in future.
¤
Two independent projects may be mutually
exclusive if a financial constraint is imposed.
If limited funds are available to accept either
project A or project B, this would be an
example of financial exclusiveness or capital
rationing.
SOURCES OF LONG -TERM FINANCE
Borrowing Debentures
SHARE CAPITAL
PUBLIC DEPOSIT
SAVING FROM NON RESIDENTS
LEASE FINANCING
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Share Capital
¤
Share Capital: Long term funds can be raised from
share capital. According to Section 86 of
Companies Act, 1956, a company can issue only
two types of shares i.e. (a) Equity shares (b)
Preference shares
Equity Shares Preference Shares



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SHARES
Equity Shares
×
Equity shareholders are known as the real
owners of the business. They have a control
over the working of the company.
×
Equity shares are paid dividend after the
preference shares.
×
At the time of winding up equity capital is
paid back after meeting all other obligations.
×
They do not have a right to get fixed
percentage of dividends.
×
The dividend depends upon the amount of
profits available. When there is no profit, they
do not get any dividend.
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Merits of Equity Shares
4 Company does not have the forced obligation to
pay dividend to equity shareholders.
4 Equity shares are a permanent source of funds
which facilitates flexibility in usage of funds.
4 The obligation to repay the equity capital arises
only at the time of liquidation of the company.
4 The shareholders can participate in the
management of the company through voting
rights.
4 Equity shares can be issued without creating any
charge over the assets.
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Demerits of Equity
Shares:
4Equity shares are always associated with the expectations of the investors.
It may not be possible to fulfill the expectations of the investors.
4Equity shareholders have to bear all the losses at the time of winding up.
4Interests of many persons are involved in the working of the company and
hence sometimes it creates delay in decision-making.
4When finance has to be raised for less risky projects, then this is not a good
source of raising finance.
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4
If only equity shares are issued then the
company can not avail the benefits of trading
on equity.
4
Investors who have a desire to invest in safe or
fixed returns have no attraction of such shares.
4
There may be danger of over-capitalization, as
equity share capital cannot be paid back during
the life time of the company.
4
Rise in the market value of shares may lead to
unhealthy speculation.
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º
In case a company wants to increase its
authorized share capital, so many legal formalities
are to be complied with.
º
Such shares have no attraction for those investors
who desire to have a regular income.
º
Such shareholders have to remain contended
without any dividend or with nominal dividend in
case of absence of profits or inadequate profits.
º
In spite of all the disadvantages, equity shares
continue to be the first choice, particularly in
initial years and in case of companies having
intermittent earnings.
Preference shares
Preference shares are those shares which
are entitled to a priority in the payment of
dividends at a fixed rate and the return of
the capital in the event of winding up of
the company.
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Types of Preference shares
4 Cumulative Preference Shares: Cumulative preference shares
are those shares on which the amount of dividend goes on
accumulating. It means that on these shares, if dividend is not
paid in one year, that dividend will be combined in the next year.
For example in the year 2007, if company is unable to pay
dividend of Rs.5,000, then in the year 2008, the company has to
pay Rs. 5,000 of 2007 and Rs. 5,000 of the year 2008.
4 Non-cumulative Preference Shares: Such shares do not have
the privilege of the accumulation of unpaid dividend. In other
words, if profits during a particular year are not sufficient, no
dividend will be paid for that year in the years to follow.
4 Participating Preference Shares: These shares get dual
benefit on the capital, first a fixed rate of dividend and then a
fraction of surplus profits left after paying dividend to equity
shareholders. The surplus profits are distributed between the
preference shares and equity shares.
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-
Non Participating Preference Shares: These shares do not
carry the additional right of sharing the surplus.
-
Redeemable Preference Shares: Those preference shares
which are to be repaid after the expiry of a certain period
of time.
-
Irredeemable Preference shares: Those shares which can
only be repaid only at the time of winding up.
-
Convertible Preference shares: Those shares which can
be converted into equity shares or other category of
preference shares after the expiry of a stipulated period
of time.
-
Non-convertible Preference Shares: Those preference
shares which cannot be converted.
Merits of Preference
Shares:
*
It provides preferential right to pay dividend and
the repayment of the capital.
*
Preference shares provide long term capital.
*
There is no liability to redeem the preference
shares except redeemable preference shares.
*
It earns a fixed rate of dividend.
*
Preference shares although carry no voting right
but the holders of such shares can vote on
matters pertaining to them.
*
Redeemable preference shares have the added
advantage of repayment of capital when there
are surplus funds with the company.
*
These shares provide strongest appeal to the
cautious investors who want to combine security
of the returns with the higher rate of return.
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Demerits of Preference
Shares:
+
It is an expensive source of finance as
compared to debt because generally the
investors expect a high return of
dividend than the interest on debentures.
+
Cumulative preference shares become a
permanent burden so far as the payment
of dividend is concerned.
+
Preference shares have no charge on the
assets so it looses the interest of the
investors.
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+
Preference shareholders are deprived of
voting rights.
+
Generally preference shareholders have no
right to participate in the surplus.
+
Preference shareholders are put to loss if
their holdings are redeemed during periods
of depression.
+
The device of sinking fund may be
introduced for the purpose of redemption
which itself is full of many abuses.
Debentures:
¤
A debenture is a document issued by the
company as an acknowledgement of debt. It is
a certificate issued by the company under its
seal acknowledging a debt due to its holder.
¤
On debentures a fixed rate of interest is paid
at regular intervals. Usually these are secured
by some asset of the company. A debenture
holder is a creditor of the company.
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Types of Debentures:
¤
Simple or Naked or Unsecured
Debentures: These debentures are not given
any security on debentures.
¤
Secured or Mortgage Debentures: These
debentures are given security on assets of the
company.
¤
Bearer Debentures: These debentures are
easily transferable. Anybody who holds these
debentures becomes the owner of such
debentures.
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¤ Registered Debentures: Registered debentures are
those debentures which are registered with the
company. These debentures can not be transferred by
mere delivery but a proper procedure is to be followed
for transfer. Both transferor and transferee are
expected to sign the transfer deed.
¤ Redeemable Debentures: These debentures are to
be redeemed on the expiry of a certain period. The
interest on debentures is paid periodically but the
principle amount is returned after a fixed period.
¤ Irredeemable / Perpetual debentures : Those
debentures which can be repaid at the time of winding
up.
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¤Convertible debentures: Those debentures which
can be converted into shares or other category of
debentures.
¤Non-Convertible debentures: Those debentures
which cannot be converted.
¤Partly Convertible debentures: When a part is
converted into shares and the remaining part is called
non-convertible portion.
¤Zero interest debentures: It is usually a convertible
debenture which yields no interest. The investor is
compensated for the loss of interest through
conversion into equity shares at a specified future
date.
Merits Of Debentures
¤
Certainty of finance for a fixed period
¤
Great market response in the days of
depression
¤
Assist in mobilisation of savings of a class
of investors which is highly cautious
¤
Provide long term funds
¤
Usually lower rate of interest than the rate
of dividend
¤
Lower effective cost
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¤
No dilution of control
¤
No effect of price level changes
¤
Flexibility in capital structure
¤
Provide regular, fixed and stable source of
earnings
¤
Safer for the holders as they have some
charge
¤
Definite maturity period
Demerits Of debentures
-
The fixed interest charges and repayment of principal
on maturity are legal obligations which have to be met.
-
Charge on assets restricts a company from using this
source of finance.
-
Cost of raising finance is high because of high stamp
duty.
-
Not useful for companies having irregular and
inadequate earnings.
-
No controlling power with the investors as they have no
voting rights
-
Interest on debentures is taxable.
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Public Deposits
¤
The third source of raising long term funds which
has been particularly popular in the textile
industry of Ahmedabad and Bombay as well as in
the tea gardens of Bengal and Assam is the public
deposits. It consists of accepting deposits by a
company from the members of public(including
shareholders and directors) for periods ranging
from six months to thirty six months.

03/04/10 01:22 AM
Advantages:
¤1) No legal formalities;
¤2) Higher dividends;
¤3) No charge on the property of the company;
¤4) Elasticity in capital structure;
¤5)Reserve fund for development;
¤6)Reasonable effective post tax cost;
¤7)Easiest source of finance;
¤8)Profitable instrument of trading on equity
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Disadvantages
¤
1)Fair-weather friend;
¤
2)Uncertain source of finance;
¤
3)Unsound source of finance;
¤
4)Inelastic source of finance;
¤
5)Costly source of finance;
¤
6)Short maturity period
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¤
7)Government restrictions;
¤
8)Higher risky for the investor;
¤
9)Neither covered by insurance nor
guaranteed by Government;
¤
10)Not as liquid as bank deposits;
¤
11)May encourage non priority sectors.
Factors Affecting long term
fund Requirements
¤
1)Nature of industry;
¤
2)Quantity of product;
¤
3)size of factory;
¤
4)Production plus marketing or merely marketing;
¤
5)Method of handling of production;
¤
6)Provision for intangible assets.
03/04/10 01:22 AM
Lease Financing
-
In addition to debt and equity financing, lease
financing has emerged as another important source
for long-term financing.
-
A lease may be defined as a contract whereby the
owner of an asset grants to another party the
exclusive right to use the asset without actually
receiving ownership title, for an agreed period of time
in return for the periodic payment of pre-determined
rentals(normally spread of the lease period). The
former is called ‘lessor’ and the latter ‘lessee’. The
lessee acquires most of the economic values
associated with the asset without acquiring title.
-
Lease financing has become popular in past three
decades or so, because of exorbitant escalation in the
cost of capital equipment.
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¤
Lease agreement must contain the following:
¤
1)The basic lease period and the condition for
non-cancellation of the lease agreement.
¤
2)The timing and amount of periodical rental
payment during the basic lease period.
¤
3)The option to renew the lease or to purchase
the asset at the end of the basic lease period.
¤
4)Particulars relating to payment of cost of
maintenance, repairs, taxes, insurance and other
expenses.
¤
5)Signing of the lease agreement.
Types of Leasing
+
Operating Lease/Real Lease/
Service Lease
+
Financial Lease/Capital Lease
03/04/10 01:22 AM
Operating Lease
¤It is a short-term lease on a period to period basis.
The lease period in such a contract is less than the
usual life of the asset.
¤The lease is usually cancellable by the lessee.
¤
The lessee usually has the option of renewing the
lease after the expiry of lease period.
¤
The lessor is generally responsible for maintenance,
insurance and taxes.
¤
Lease rentals are higher as compared to other
leases.
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Operating lease is suitable in the
following cases:
1)Assets which have rapid obsolescence;
2)Overcoming the temporary financial
problems of the lessee by taking the
equipment on operating lease as well as
postponing to buy the same.
Financial Lease
×
A financial lease is a non-cancellable
contractual commitment on the part of a lessee
to make a series of payments to the lessor for
the use of an asset. With a financial lease, the
lease period generally corresponds to the
economic life of the asset.
×
Most of the leases in India are financial leases
that are commonly used for leasing land,
buildings, office equipments, diesel generators,
earth moving equipments, locomotives and
hotel equipment etc.
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¤
The present value of the total lease rentals
payable during the period of the lease
exceeds or is equal to the substantially the
whole of the fair value of the leased asset.
¤
As compared to the operational lease, a
financial lease is for a long period of time.
¤
It is usually non-cancellable by the lessee
prior to its expiration date.
¤
The lessee is generally responsible for
maintenance, insurance and service of the
asset.
Forms of Financial Lease
+
Sale and Lease back
+
Direct leasing
+
Leveraged Leasing
+
Straight Lease and Modified Lease
+
Primary and secondary Lease
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Sale and Lease Back
-Under a sale and lease back arrangement, a firm
sells an asset to another party, and this party
leases it back to the firm.
-Usually the asset is sold at its market value. The
firm receives sale price in cash and the economic
use of the asset during the lease period. In turn, it
contracts to make periodic lease payments and
gives up the title of the asset. Residual value will
now belong to the lessor and not to the firm.
-Lessors engaged in this include insurance
companies, finance companies and other
institutional investors.
03/04/10 01:22 AM
Direct Leasing
×
Under Direct leasing, a firm acquires the use of
an asset that it does not already own.
×
A direct lease may be arranged either from the
manufacturer or through the leasing company. A
wide variety of direct leasing arrangements meet
various needs of firms.
×
For leasing arrangements involving all but
manufacturers, the vendor sells the asset to the
lessor, who in turn leases it to the lessee. In
certain cases, the lessor may achieve economies
of scale in the purchase of capital assets and may
pass them on to the lessee at lower lease rentals.
03/04/10 01:22 AM
Leveraged lease
-
A leveraged lease is an arrangement under which the
lessor borrows funds, for purchasing the asset, from a
third party called lender, which is usually a bank or
finance company. Generally 20% to 50% of cost is
contributed by the lessor. The loan is usually secured
by the mortgage of the asset and the lease rentals to
be received from the lessee. From the standpoint of
lessee there is no difference between this lease and
any other lease.
-
In this type of lease, a wide range of equipments such
as rail-road rolling stocks, coal mining, electricity,
generating plants, pipelines, ships etc. are acquired.
03/04/10 01:22 AM
Straight Lease and Modified
Lease
¤
Straight lease requires the lessee firm to pay
lease rentals over expected life of the asset
and does not provide for any modifications to
the terms and conditions of the basic lease.
¤
Modified Lease, on the other hand, provides
several options to the lessee during the lease
period. For example, the option of terminating
lease may be provided by either purchasing
the asset or returning the same.
03/04/10 01:22 AM
Primary and Secondary Lease
(Front-ended and back-ended
Lease)
¤
Under primary and secondary lease, the lease
rentals are charged in such a manner that the
lessor recovers the cost of asset and
acceptable profits during the initial period of
the lease and then secondary lease is
provided at nominal rentals. In other words,
the rent charged in the primary period are
much more than that of the secondary period.
03/04/10 01:22 AM
Advantages of lease to the
Lessee
+
Avoidance of Initial Cash Outlay
+
Minimum Delay
+
Easy source of finance
+
Shifting the risk of obsolesence
+
Enhanced Liquidity
+
Tax planning and Advantage
+
Higher return on capital employed
+
Convenience and Flexibility
03/04/10 01:22 AM
Disadvantages
+
Higher Cost
+
Risk of being deprived of the use of asset
+
Loss of ownership incentives
+
Penalty on termination of lease
+
Loss of salvage value of the asset
+
No alteration or change in asset
03/04/10 01:22 AM
Advantages of Leasing to the
Lessor
×
Higher profits
×
Tax Benefits
×
Quick Returns
×
Increased Sales
×
Benefits of residual value
03/04/10 01:22 AM
Limitations of Leasing to the
Lessor
×
High risk of Obsolescence
×
Competitive Market
×
Price-level Changes
×
Management of cash flows
×
Increased cost due to the loss of user benefit
×
Long-term investment
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03/04/10 01:22 AM
¤
AS-19, as issued by ICAI, prescribes for
lessees and lessors, the appropriate
accounting policies and disclosures in relation
to finance leases and operating leases. This
standard came into effect in respect of all
assets leased during accounting periods
commencing on or after April 1,2001 and is
mandatory in nature.
Capital Structure
-Capital structure refers to the composition or make-up
or mix of capital i.e. in what proportion equity share
capital, preference share capital, long term loans and
debentures have been issued.
-Capitalization refers to the sum total of all kinds of long
term securities i.e. equity share capital, preference
share capital and long term loans and debentures.
-Financial structure refers to all the financial resources,
short as well as long term. In nutshell it is the sum
total of the liability side of the balance sheet.

03/04/10 01:22 AM
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According to Gerstenberg, ‘capital structure of a company
refers to the make-up of its capitalization’.
There are no ready made rules so far as the proportion of
different types of securities is concerned. However,
Gerstenberg has given two general principles in this regard.
1)The greater the stability of earnings, the higher may be the
ratio of bonds to stock in capital structure.
2)The capital structure should be balanced with a sufficient
equity cushion to absorb the shocks of business cycle and to
afford flexibility.
Theories of Capital
Structure
¤
Net Income Approach
¤
Net Operating Income Approach
¤
Traditional Approach
¤
Modigliani and Miller Approach
03/04/10 01:22 AM
Net Income Approach
¤
According to this approach, a firm can minimise
the weighted average cost of capital and increase
the value of the firm as well as market price of
equity share by using debt financing. The theory
propounds that a company can increase its value
and reduce the overall cost of capital by
increasing the proportion of debt in its capital
structure. The basic Assumptions are:
¤
The cost of debt is less than the cost of equity.
¤
There are no taxes.
¤
The risk perception of investors is not changed by
the use of debt.
03/04/10 01:22 AM
Net Operating Income
Approach
¤
According to this approach, change in capital
structure of a company does not affect the
market value of the firm and the overall cost
of capital remains constant irrespective of
the method of financing. The main
assumptions are:
¤
The market capitalizes the value of the firm
as a whole.
¤
The business risk remains constant at every
level of debt-equity mix.
¤
There are no corporate taxes.
03/04/10 01:22 AM
Traditional Approach
¤
According to this theory, the value of the firm
can be increased initially or the cost of capital
can be decreased by using more debt as the
debt is a cheap source of finance. Beyond a
particular point, the cost of equity increases
because increased debt increases the
financial risk of equity shareholders.
03/04/10 01:22 AM
Modigliani and Miller
approach
¤
In the absence of Taxes
The theory proves that the cost of capital is not
affected by the changes in the capital
structure. The reason argued is that though
debt is cheaper to equity, with increased use
of debt as a source of finance, the cost of
equity increases.
03/04/10 01:22 AM
When the corporate taxes are
assumed to exist
¤
The value of the firm will increase or the cost
of capital will decrease with the use of debt on
account of deductibility of interest charges for
tax purposes.
03/04/10 01:22 AM
Factors determining Capital
Structure
¤
Financial Leverage or
Trading on Equity
¤
Growth and stability of
sales
¤
Cost of Capital
¤
Nature and Size of Firm
¤
Control
¤
Flexibility
¤
Requirement of Investors
¤
Capital Market
Requirements
¤
Asset Structure
¤
Purpose of Financing
¤
Period of Finance
¤
Personal
Considerations
¤
Corporate Tax rate
¤
Legal Requirements
03/04/10 01:22 AM
Cost of capital
-
Cost of capital refers to the minimum required
rate of return of a proposal that a company must
earn to cover the cost of investment. Funds can
be procured from different sources such as equity
and preference shareholders, debt holders and
depositors. All those who have invested in the
company, would require a return on their
investment.
-
To satisfy the expectations of the stakeholders,
the projects of the firm must be able to attain a
minimum cut-off rate. Capital raised from
different sources is called components of capital.
Each of these sources has a cost.
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03/04/10 01:22 AM
¤
Cost of capital is “ a cut-off rate for the allocation
of capital to investments of projects. It is the rate
of return on a project that will leave unchanged
the market price of stock.’’--------James C. Van
Horne
¤
“ Cost of capital is the minimum required rate of
earnings or the cut-off rate of capital
expenditures.”
¤
Cost of capital is “the rate of return the firm
requires from investment in order to increase the
value of the firm in the market place.”
Significance of Cost of
Capital
¤
As an acceptance criteria in Capital Budgeting
¤
As a determinant of capital mix in capital
structure decisions
¤
As a basis for evaluating the financial
performance
¤
As a basis for taking other financial decisions
03/04/10 01:22 AM
Computation of Cost of
Capital
¤
Cost of Debt
K
d
=I/P
Where, K
db=
Before tax Cost of Debt
I= Interest
P= Principal Amount
If debt is issued at Premium or Discount
K
db=
I/NP (Where NP= Net Proceeds)
After-taxcost of debt

K
da=I/NP(1-t)
Where
K
da=After taxcost of
debt
t=Rate of tax
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Cost of Redeemable Debt
¤
Before Tax cost of Debt

Where I=Annual Interest
n=No. of years on which debt is to be redeemed
RV=Redeemable value of debt
NP=Net proceeds of debentures
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Cost of Redeemable Debt
¤
After Tax cost of redeemable debt
03/04/10 01:22 AM
Where I=Annual Interest
t=Tax rate
n=No. of years on which debt is to be redeemed
RV=Redeemable value of debt
NP=Net proceeds of debentures
Cost of Preference Shares
¤K
p
= D/P
K
p=Cost of Preferencecapitals
D=Annual PreferenceDividend
P=PreferenceShareCapital
¤
Redeemable Preference Share
K
pr
=D+MV-NP
Where K
pr
= Cost of Redeemable Preference Share
D= Annual Preference Dividend
MV= Maturity Value of Preference Share
NP= Net Proceeds of Preference Shares
03/04/10 01:22 AM
Cost of Equity Shares
- Ke= D/NP or D/MP
Ke= Cost of Equity Capital
D= Expected dividend per share
NP= Net proceeds per share
MP=Market price per share
Dividend yield plus growth in dividend method
Ke=D/NP+G
Ke= Cost of Equity Capital
D= Expected dividend per share
NP= Net proceeds per share
G= Rate of growth in dividends
03/04/10 01:22 AM
Cost of Retained Earnings
¤
Kr= (D/NP+G)x(1-t)x(1-b)
Where Kr = Cost of Retained Earnings
D = Expected Dividend
NP= Net Proceeds of Equity Issue
G = Rate of Growth
t = Tax rate
b = Brokerage cost etc.
03/04/10 01:22 AM
Weighted Average Cost Of
Capital
¤
It is the average cost of the costs of various sources of
financing. It is also called composite cost of capital,
overall cost of capital or average cost of capital.
¤
Once the specific cost of individual sources of finance is
determined, we can compute weighted average cost of
capital by putting weights to the specific cost of capital in
proportion of the various sources of funds to the total.
Kw= ∑XW
∑W
Where, Kw= weighted average cost of capital
X = cost of specific source of finance
W = weight, proportion of specific source of
finance

03/04/10 01:22 AM
Leverages
-Leverage has been defined as the action of a lever ,
and the mechanical advantage gained by it. It allows
us to accomplish certain things i.e., Lifting of heavy
objects etc.
- In financial management, the term leverage is used
to describe the firm’s ability to use fixed cost assets
or funds to increase the return to its investors i.e.
equity shareholders. The capital structure of a
company is said to be leveraged or geared when
there is the presence of debt in it.
03/04/10 01:22 AM
03/04/10 01:22 AM
¤
The concept of leverage assumes significance
if one appreciates that different investors
have different attitudes towards risk and
return.
¤
Some like to bear more risks in the hope of
earning good returns while others prefer fixed
and regular income even at a lower rate
provided risk involved is less.
¤
The former category makes investment in
equity share capital while the latter in fixed
income bearing securities.
03/04/10 01:22 AM
-
The company chooses a suitable leverage with
another objective also. It has to ensure to its
equity shareholders an adequate amount of
dividend as they are the actual risk bearers.
This amply compensates the real owners of
the company for no dividend or little dividend
allowed to them in the years of lean profits.
-
The right gearing/ leverage of capital is also
important for a correct policy of dividend
distribution and creation of reserves.
03/04/10 01:22 AM
¤
To quote Brown and Howard ‘It(capital gearing
or leverage) must be carefully planned since it
affects company’s capacity to maintain an
even distribution in the face of any difficult
trading periods which may occur.
¤
Furthermore its immediate effect may be to
enable a company to pay higher ordinary
dividends when there is only a narrow margin
of profit but its long term effects on the
efficiency of the company are far reaching.’
Types of leverages
¤
There are basically two types of
leverages
¤
Financial Leverage
¤
Operating Leverage
03/04/10 01:22 AM
Financial Leverage
-
It is also called trading on equity. A company
may raise funds either by way of equity or debt.
When a concern uses borrowed funds as well as
owned capital, it is said to be trading on equity.
-
The philosophy behind trading on equity is to
evolve such a capital structure which involves
minimum cost of capital and ensures maximum
return to equity shareholders.
-
Return is a function of risk, debentures and
preference shares being more secure attract
less return than dividend on equity shares.
03/04/10 01:22 AM
03/04/10 01:22 AM
¤
“The degree to which debt is used in
acquiring assets is known as trading on
equity.”------Hastings
¤
“the use of borrowed funds or preferred stock
for financing is known as trading on equity.”---
Guthman and Dougall
¤
“When a person or a corporation uses
borrowed capital as well as owned capital in
the regular conduct of its business, he or it is
said to be trading on equity.”
Illustration
◦ A firm is considering two financial plans with a view
to examining their impact on earnings per share
(EPS). The total funds required for investment in
assets are Rs. 5,00,000
◦ Debt(10%) 4,00,000 1,00,000
◦ Equity shares 4,00,000 1,00,000
◦ Total 5,00,000 5,00,000
◦ No. of equity shares 40,000 10,000

◦ EBIT are assumed to be Rs. 50,000, Rs.75,000 and
Rs. 1,25,000. The rate of tax is 50%. Comment
03/04/10 01:22 AM
Significance of financial leverage
¤
1)Planning of capital structure:
The capital structure is concerned
with the raising of long-term funds
both from shareholders and long-term
creditors. A financial manager has to
decide about the ratio between fixed
cost funds and equity share capital.
The effect of borrowings on cost of
capital and financial risk have to be
decided before selecting a final
capital structure.
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03/04/10 01:22 AM
¤
2)Profit Planning: The earning per share is
effected by the degree of financial leverage. If
the profitability of the concern is regular and
sufficient, then fixed cost funds will help in
increasing the availability of profits for equity
shareholders.
Limitations of financial
leverage
¤
1)Double-edged weapon: Trading on
equity is a double-edged weapon. It can
be successfully employed to increase
the earnings of the company for equity
share holders if debt can be raised at a
rate which is less than the rate of
dividend. On the other hand, if it does
not earn as much as the cost of interest
bearing securities, then it will work
adversely and hence can not be
employed.
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03/04/10 01:22 AM
¤
2) Benefits only to those companies
which have stability of earnings:
Trading on equity can be enjoyed only by
those companies which have adequate,
stable and regular earnings. This is so
because interest on debentures is a
recurring burden on the company and has
to be paid whether there is profit or not.
03/04/10 01:22 AM
- 3) Increased risk and rate of interest:
Another limitation of trading on equity is on
account of the fact that every rupee of extra
debt increases the risk and hence the rate of
interest on subsequent borrowings also goes
on increasing. It become difficult for the
company to obtain further debts without
offering extra securities and higher rate of
interest, which may result in reduced
earnings.
03/04/10 01:22 AM
¤
4)Restriction from financial
institutions: The financial institutions also
impose restrictions on companies which
resort to excessive trading on equity
because of the risk factor and to maintain a
balance in the capital structure of the
company.
Operating Leverage
- Operating leverage takes place when a change in revenue
produces a greater change in EBIT. It indicates the impact
of changes in sales on operating income.
- A firm with a high operating leverage has a relatively on
EBIT for small changes in sales. A small rise in sales may
enhance profits considerably, while a small decline in sales
may reduce and even wipe out the EBIT. NO firm likes to
operate under conditions of a high operating leverage as it
creates a high risk situation. It is always safe for a firm to
operate sufficiently above the break even point to avoid
dangerous fluctuations in sales and profits.
- The operating leverage is related to fixed costs.
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03/04/10 01:22 AM
¤
A firm with relatively high fixed costs uses much
of its marginal contribution to cover fixed costs.
It is interesting to note that beyond the break-
even point, the marginal contribution is
converted into EBIT. The operating leverage is
highest near the break even point.
¤
Operating Leverage= Marginal
Contribution/EBIT

03/04/10 01:22 AM
Combined Leverage
-Financial leverage is the result of financial decisions.
Operating leverage affects the income which is the result
of production. Combined leverage focuses attention on
the entire income of the concern. The risk factor should
be properly assessed by the management before using
the composite leverage.
-Degree of composite leverage
= Percentage change in EPS/Percentage change in sales


03/04/10 01:22 AM
Meaning of Working
Capital
-Working capital refers to that part of total capital which
is required for meeting routine and repetitive expenses
of day-to-day business operations e.g. working capital
will stand invested in raw-materials and stock, debtors,
cash and bank balance. Expenses like wages, salaries,
rents, rates etc. are met from these sources.
-In simple words it is the amount required for day-to-day
running of the business. It can be aptly compared with a
river which remains there every time but the water in it
is constantly changing. That is why it is also called
‘fluctuating’ ‘revolving’ ‘floating’ ‘circulating’ capital.
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03/04/10 01:22 AM
-
“Working capital means current assets.”
---Mead, Mallot and Field
-
“The sum of the current assets is the working capital of
the business.”-----------J.S.Mill
-
“Circulating capital means current assets of a company
that are changed in the ordinary course of business
from one form to another, as for example from cash to
inventories, inventories to receivables and receivables
to cash.”---------------------Gerestenberg
-
“Working capital is descriptive of that capital which is
not fixed. But the more common use of working capital
is to consider it as difference between book value of
the current assets and current liabilities.”----Hoagland
03/04/10 01:22 AM
¤
From these definitions it can be observed that according to
some authorities working capital is equal to the sum total of
current assets, while according to others it is the excess of
current assets over the current liabilities. To avoid this
confusion two different concepts have come into existence.
¤
1)Gross working capital: Which is equal to the some total of
current assets.
¤
2)Net working capital: Which is equal to the excess of current
assets over current liabilities.
¤
The modern view is increasingly in favour of net working
capital.
¤
That is why when we talk of working capital, it refers
to the excess of current assets over current liabilities.
Classification/Kinds of
Working Capital
¤
Permanent or Regular working Capital
1)Permanent working capital
2)Reserve working capital
¤
Temporary or Variable Working capital
1)Seasonal working capital
2)Special working capital
03/04/10 01:22 AM
Advantages of adequate
Working Capital
¤
Index of sound liquidity position;
¤
Facility of cash discount;
¤
Prompt payment to suppliers;
Easy loans from banks;
¤
Attractive dividends;
¤
Creation of goodwill;
¤
Meeting special needs;
¤
Survival during adverse business conditions;
¤
Off season purchasing;
¤
High morale
03/04/10 01:22 AM
Factors Determining Working
Capital Requirements
¤
Nature of business;
¤
Size of the business;
¤
Proportion of raw material cost to total
cost;
¤
Nature of industry;
¤
Time lag in production;
¤
Rapidity of turnover;
¤
Need for stock-piling;
03/04/10 01:22 AM
03/04/10 01:22 AM
¤
Terms and conditions of purchase and sale;
¤
Requirements of cash;
¤
Relation with the banks;
¤
Policy regarding dividends;
¤
Seasonal variations;
¤
Cyclical fluctuations;
¤
Price level changes;
¤
Other factors.
Dangers of Redundant
Working Capital
-
Redundant working capital denotes a
situation of too much or excessive working
capital. Its existence is not a welcome sign as
it reflects poor management of funds.
-
Lack of steady return
-
Distortions in current ratio
-
Reckless purchasing
-
Lack of activity
-
Affects relations with banks
-
Chances of excessive bad debts
03/04/10 01:22 AM
Financing of Long-term working
Capital
¤
Shares
¤
Debentures
¤
Public Deposits
¤
Retained earnings
¤
Loans from Financial Institutions
03/04/10 01:22 AM
Financing of short-term Working
Capital
¤
Indigenous Bankers
¤
Trade Credit
¤
Instalment Credit
¤
Advances
¤
Factoring/Accounts receivable credit
¤
Accrued Expenses
¤
Deferred Incomes
¤
Commercial Papers
¤
Commercial banks
03/04/10 01:22 AM
Retained earnings or ploughing
back of profits
¤
Retained earnings is a technique of financial
management under which all the profits of a
company are not distributed among the
shareholders as dividend, but a part of it is
retained/reinvested in the company. This
process of retaining profits year after year is
known as ploughing back of profits.
03/04/10 01:22 AM
Necessity of Retained
Earnings
¤
For the replacement of assets which have
become/will be obsolete.
¤
For the expansion and growth of business.
¤
For contributing towards the fixed as well as
working capital needs of the company.
¤
For making the company self-dependent of
finance from outside sources.
¤
For redemption of loan and debentures.
03/04/10 01:22 AM
Advantages of Retained
Earnings:
From Companies Point of View
¤
A Cushion to absorb the shocks of business
oscillations.
¤
Economical method of financing
¤
Helps on following stable dividend policy
¤
Flexible financial structure
¤
Makes the company self-dependent
¤
Enables to redeem the long-term liabilities
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From Shareholders point of
view
¤
Increase in the value of shares
¤
Safety of Investment
¤
No dilution of control
¤
Evasion of super tax
03/04/10 01:22 AM
Disadvantages of Retained
Earnings:
¤
Over-capitalization
¤
Creation of Monopolies
¤
Misuse of retained earnings
¤
Manipulation in the value of shares
¤
Evasion of Taxes
¤
Dissatisfaction among Shareholders
03/04/10 01:22 AM
Management of Earnings
-
Procurement of adequate amount of capital,
although a significant task before management, is
not the be-all and end-all of the entire duties of
management.
-As a matter of fact, the dexterity of management
lies more in management of earnings than in
procurement of capital. After obtaining the
necessary amount of capital, the next important
function is to invest and utilize the raised capital in
such a way that the investors may get an adequate
return and the capital too may remain intact.
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¤
Efficient utilization of capital and the
management of earnings are delicate issues. Prior
to the distribution of profits in the form of
dividends, a part is retained for the rainy days, in
the form of reserves. Creation of ill-planned
reserves, unsound depreciation policy and
absence of scientific internal financial control are
symbols of defective management of earnings
and may even lead to liquidation.
Scope of management of
earnings
¤
Management of earnings includes:
¤
Determination of Profits
¤
Determination of Surpluses
¤
Creation of Reserves
¤
Provision of Depreciation
¤
Declaration of Dividend
¤
Retained Earnings
03/04/10 01:22 AM
Sources of Profits
¤
Income from Business
¤
Income from other sources
¤
Income from Investments
03/04/10 01:22 AM
Kinds and Sources of
Surpluses
¤
Earned Surpluses
¤
Capital Surpluses
¤
Surpluses from Unrealised appreciation of
assets
¤
Surpluses from realised appreciation of assets
¤
Surpluses from Mergers
¤
Surpluses from reduction of Share Capital
¤
Surpluses from Secret Reserves
03/04/10 01:22 AM
Reserves
¤
The term Reserve refers to the amount set
aside out of profits. The amount may be set
aside to cover any liability, contingency,
commitment or depreciation in the value of
the assets.
03/04/10 01:22 AM
Classification of Reserves
¤
General Reserves
¤
Special Reserves
¤
Capital Reserves
¤
Revenue Reserves
¤
Assets Reserves
¤
Liability Reserves
¤
Funded Reserves
¤
Sinking Fund Reserves
¤
Secret Reserves
¤
Proprietary Reserves
03/04/10 01:22 AM
Dividend Policy
-
Dividend refers to that part of the profit which
is distributed by the company among its
shareholders.
-
It is the reward of the shareholders for
investment made by them in the shares of
the company. Whole of the profit cannot be
distributed as dividend as the company has to
make provision for its rainy days.
-
Dexterity of the management lies in striking a
balance between dividend paid and the
amount retained for the purpose of self
financing.
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-The dividend policy should be designed in such a
fashion that the shareholders are not deprived of
their due and the interests of the company are not
adversely affected so far as future growth
prospects are concerned. That dividend policy is
considered satisfactory which permits distribution
of regular dividends at a gradually increasing rate.
-If a company earns huge profits in a particular
year, it is advisable to increase the rate of
dividend marginally.
Types of Dividend Policies
¤
Regular Dividend Policy
¤
Stable Dividend policy
¤
Irregular Dividend policy
¤
No dividend Policy
03/04/10 01:22 AM
Forms of Dividends
¤
Cash Dividend
¤
Bond Dividend/Scrip Dividend
¤
Property Dividend
¤
Stock Dividend
03/04/10 01:22 AM
Considerations in dividend
policy
¤
Legal restrictions
¤
Magnitude and trend of earnings
¤
Desire and type of shareholders
¤
Nature of industry
¤
Age of the company
¤
Future financial requirements
¤
Government’ economic policy
¤
Taxation policy
¤
Inflation
¤
Control objectives
¤
Requirements of institutional investors
¤
Stability of dividends
¤
Liquid resources
03/04/10 01:22 AM
Forms of Dividend
Theories:
¤
The Irrelevance Concept of Dividend or the
Theory of Irrelevance
1)Residual Approach
2)Modigliani and Miller Approach(MM Model)
¤
The Relevance Concept of Dividend or the
Theory of Relevance
1)Walter’s Approach
2)Gordon’s Approach
03/04/10 01:22 AM
Bonus Shares
-When a company has huge accumulated reserves, it
may decide to distribute a part of these reserves
among its equity shareholders.
-No company will generally like to distribute these
reserves in the form of cash, as it may adversely
affect its working capital position. Therefore, in lieu
of such reserves, shares are issued which are called
bonus shares. This process of issuing bonus shares
is also called capitalisation of reserves
03/04/10 01:22 AM
Sources of Bonus Shares
º
Balance in Profit and Loss Account
º
General Reserve
º
Capital Reserve
º
Share Premium account(received in cash)
º
Balance in sinking fund for redemption of debentures, after
debentures have been redeemed
º
Development rebate reserve, development allowance
reserve etc. allowed under Income Tax Act, 1961 after the
expiry of a specified period i.e. 8years.
º
Capital redemption reserve account
º
Other free revenue reserves
º
Share premium and CRR can only be used to issue
fully paid bonus shares.

03/04/10 01:22 AM
Advantages of Bonus
Shares
-
From Company’s point of view
-
Helps to get rid of market influences
-
Helpful in showing correct earning capacity
-
Liquidity position is not effected
-
Enhanced creditworthiness
-
Decreased rate of dividend has positive impact on
employees and consumers
-
Realistic picture of capital structure in Balance Sheet
When a company pays bonus to its shareholders in the value
of shares and not in cash, its liquid resources are
maintained and working capital is not affected
It is cheaper method of raising additional capital for the
expansion of the business.
03/04/10 01:22 AM
From shareholders’ point of
view
¤
The bonus shares are permanent source of
income to the investors.
¤
The investors can easily sell these shares and
get immediate cash, if they desire so.
¤
Even if the rate of dividend falls, the total
amount of dividend may increase as the
investor gets dividend on a large number of
shares.
03/04/10 01:22 AM
Disadvantages of Bonus
Shares
¤
The reserves of the company after bonus
shares decline and leaves lesser security to
the investors.
¤
The fall in future rate of dividend results in the
fall of the market price of shares.
¤
The issue of bonus shares leads to a drastic
fall in the future rate of dividend.
03/04/10 01:22 AM
Corporate Restructuring
¤
Restructuring is the corporate management term for the
act of partially dismantling and reorganizing a company for
the purpose of making it more efficient and therefore, more
profitable. It generally involves selling off portions of the
company and making severe staff reductions.
¤
Restructuring is often done as part of a bankruptcy or of a
takeover by another firm, particularly a leveraged buyout by
a private equity firm. It may also be done by a new CEO
hired specifically to make the difficult and controversial
decisions required to save or reposition the company.
03/04/10 01:22 AM
Characterstics
-
The selling of portions of the company, such as a division
that is no longer profitable or which has distracted
management from its core business, can greatly improve the
company's balance sheet.
-
Staff reductions are often accomplished partly through the
selling or closing of unprofitable portions of the company
and partly by consolidating or outsourcing parts of the
company that perform redundant functions (such as payroll,
human resources, and training) left over from old
acquisitions that were never fully integrated into the parent
organization.
03/04/10 01:22 AM
Other characteristics of
restructuring can include:

Changes in corporate management (usually with golden parachutes)

Sale of underutilized assets, such as patents or brands

Outsourcing of operations such as payroll and technical support to a
more efficient third party

Moving of operations such as manufacturing to lower-cost locations

Reorganization of functions such as sales, marketing, and
distribution

Renegotiation of labor contracts to reduce overhead

Refinancing of corporate debt to reduce interest payments

A major public relations campaign to reposition the company with
consumers
03/04/10 01:22 AM
Results
¤
A company that has been restructured effectively will
generally be leaner, more efficient, better organized, and
better focused on its core business. If the restructured
company was a leverage acquisition, the parent company
will likely resell it at a profit when the restructuring has
proven successful.
03/04/10 01:22 AM
03/04/10 01:22 AM
Merger and acquisitons
Definition
-
One plus one makes three: this equation is the special
alchemy of a merger or an acquisition .
-
The key principle behind buying a company is to create
shareholder value over and above that of the sum of the two
companies. Two companies together are more valuable than
two separate companies - at least, that's the reasoning
behind M&A. This rationale is particularly alluring to
companies when times are tough.
-
Strong companies will act to buy other companies to create a
more competitive, cost-efficient company. The companies will
come together hoping to gain a greater market share or to
achieve greater efficiency. Because of these potential
benefits, target companies will often agree to be purchased
when they know they cannot survive alone.
03/04/10 01:22 AM
Distinction between Mergers
and Acquisitions
¤
Although they are often uttered in the same breath and used
as though they were synonymous, the terms merger and
acquisition mean slightly different things.
¤
When one company takes over another and clearly
established itself as the new owner, the purchase is called an
acquisition. From a legal point of view, the target company
ceases to exist, the buyer "swallows" the business and the
buyer's stock continues to be traded.
¤
In the pure sense of the term, a merger happens when two
firms, often of about the same size, agree to go forward as a
single new company rather than remain separately owned
and operated. This kind of action is more precisely referred to
as a "merger of equals." Both companies' stocks are
surrendered and new company stock is issued in its place
03/04/10 01:22 AM
Example
-For example, both Daimler-Benz and Chrysler ceased
to exist when the two firms merged, and a new
company, Daimler Chrysler, was created.
-In practice, however, actual mergers of equals don't
happen very often. Usually, one company will buy
another and, as part of the deal's terms, simply allow
the acquired firm to proclaim that the action is a
merger of equals, even if it's technically an
acquisition.
-Being bought out often carries negative
connotations, therefore, by describing the deal as a
merger, deal makers and top managers try to make
the takeover more palatable.
03/04/10 01:22 AM
03/04/10 01:22 AM
-
A purchase deal will also be called a merger when
both CEOs agree that joining together is in the best
interest of both of their companies. But when the deal
is unfriendly - that is, when the target company does
not want to be purchased - it is always regarded as an
acquisition.
-
Whether a purchase is considered a merger or an
acquisition really depends on whether the purchase is
friendly or hostile and how it is announced. In other
words, the real difference lies in how the purchase is
communicated to and received by the target
company's BOD , employees and shareholders.
By merging, the companies
hope to benefit as follows :
Q
Staff reductions - As every employee knows, mergers tend to
mean job losses. Consider all the money saved from reducing
the number of staff members from accounting, marketing and
other departments. Job cuts will also include the former CEO,
who typically leaves with a compensation package.
Q
Economies of scale Yes, size matters. Whether it's purchasing
stationery or a new corporate IT system, a bigger company
placing the orders can save more on costs. Mergers also
translate into improved purchasing power to buy equipment or
office supplies - when placing larger orders, companies have a
greater ability to negotiate prices with their suppliers.
03/04/10 01:22 AM
03/04/10 01:22 AM
Q
Acquiring new technology - To stay competitive,
companies need to stay on top of technological
developments and their business applications. By buying
a smaller company with unique technologies, a large
company can maintain or develop a competitive edge.
Q
Improved market reach and industry visibility -
Companies buy companies to reach new markets and
grow revenues and earnings. A merge may expand two
companies' marketing and distribution, giving them new
sales opportunities. A merger can also improve a
company's standing in the investment community: bigger
firms often have an easier time raising capital than
smaller ones.
03/04/10 01:22 AM
-
That said, achieving synergy is easier said than done - it
is not automatically realized once two companies merge.
Sure, there ought to be economies of scale when two
businesses are combined, but sometimes a merger does
just the opposite. In many cases, one and one add up to
less than two.
-
Sadly, synergy opportunities may exist only in the minds
of the corporate leaders and the deal makers. Where
there is no value to be created, the CEO and investment
bankers - who have much to gain from a successful M&A
deal - will try to create an image of enhanced value. The
market, however, eventually sees through this and
penalizes the company by assigning it a discounted
share price. We'll talk more about why M&A may fail in a
later section of this tutorial.
Varieties of Mergers
From the perspective of business structures, there is a whole
host of different mergers. Here are a few types, distinguished
by the relationship between the two companies that are
merging:
Q
Horizontal Merger- Two companies that are in direct
competition and share the same product lines and markets.
Q
Vertical Merger- A customer and company or a supplier and
company. Think of a cone supplier merging with an ice cream
maker.
Q
Market-extension merger - Two companies that sell the same
products in different markets.
Q
Product-extension merger - Two companies selling different
but related products in the same market.
Q
Conglomeration - Two companies that have no common
business areas.
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03/04/10 01:22 AM
There are two types of mergers that are distinguished by
how the merger is financed. Each has certain implications
for the companies involved and for investors:
Q
Purchase Mergers - As the name suggests, this kind of merger
occurs when one company purchases another. The purchase is
made with cash or through the issue of some kind of debt
instrument; the sale is taxable.
Acquiring companies often prefer this type of merger because
it can provide them with a tax benefit. Acquired assets can be
written-up to the actual purchase price, and the difference
between the book value and the purchase price of the assets
can depreciate annually, reducing taxes payable by the
acquiring company.
Q
Consolidation Mergers - With this merger, a brand new
company is formed and both companies are bought and
combined under the new entity. The tax terms are the same as
those of a purchase merger.
Acquisitions
-
As you can see, an acquisition may be only slightly different from
a merger. In fact, it may be different in name only. Like mergers,
acquisitions are actions through which companies seek
economies of scale, efficiencies and enhanced market visibility.
Unlike all mergers, all acquisitions involve one firm purchasing
another - there is no exchange of stock or consolidation as a
new company. Acquisitions are often congenial, and all parties
feel satisfied with the deal. Other times, acquisitions are more
hostile.
-
In an acquisition, as in some of the merger deals we discuss
above, a company can buy another company with cash, stock or
a combination of the two. Another possibility, which is common in
smaller deals, is for one company to acquire all the assets of
another company. Company X buys all of Company Y's assets
for cash, which means that Company Y will have only cash (and
debt, if they had debt before). Of course, Company Y becomes
merely a shell and will eventually liquidate or enter another area
of business.
03/04/10 01:22 AM
03/04/10 01:22 AM
-
Another type of acquisition is a reverse merger, a deal that
enables a private company to get publicly-listed in a relatively
short time period. A reverse merger occurs when a private
company that has strong prospects and is eager to raise
financing buys a publicly-listed shell company, usually one
with no business and limited assets. The private company
reverse merges into the public company, and together they
become an entirely new public corporation with tradable
share.
-
Regardless of their category or structure, all mergers and
acquisitions have one common goal: they are all meant to
create synergy that makes the value of the combined
companies greater than the sum of the two parts. The
success of a merger or acquisition depends on whether this
synergy is achieved
Types of Acquisitions
An acquisition can take the form of a purchase of the stock or other
equity interests of the target entity, or the acquisition of all or a
substantial amount of its assets.
Q
Share purchases - in a share purchase the buyer buys the shares of the
target company from the shareholders of the target company. The buyer
will take on the company with all its assets and liabilities.
Q
Asset purchases - in an asset purchase the buyer buys the assets of the
target company from the target company. In simplest form this leaves
the target company as an empty shell, and the cash it receives from the
acquisition is then paid back to its shareholders by dividend or through
liquidation. However, one of the advantages of an asset purchase for
the buyer is that it can "cherry-pick" the assets that it wants and leave
the assets - and liabilities - that it does not. This leaves the target in a
different position after the purchase, but liquidation is nevertheless
usually the end result.
03/04/10 01:22 AM
Mergers are generally differentiated from acquisitions partly by the way
in which they are financed and partly by the relative size of the
companies. Various methods of financing an M&A deal exist:
03/04/10 01:22 AM
All shares deal
A "merger" or "merger of equals" is often financed by an all stock
deal (a stock swap), known in the UK as an all share deal. Such
deals are considered mergers rather than acquisitions because
neither company pays money, and the shareholders of each company
end up as the combined shareholders of the merged company. There
are two methods of merging companies in this way:
Q
one company takes ownership of the other, issuing new shares in
itself to the shareholders of the company being acquired as payment,
or
Q
a third company is created which takes ownership of both
companies (or their assets) in exchange for shares in itself issued to
the shareholders of the two merging companies.
Where one company is notably larger than the other, people may
nevertheless be wary of calling the deal a merger, as the
shareholders of the larger company will still dominate the merged
company.
03/04/10 01:22 AM
03/04/10 01:22 AM
A company acquiring another will frequently pay for the
other company by cash. Such transactions are usually
termed acquisitions rather than mergers because the
shareholders of the target company are removed from the
picture and the target comes under the (indirect) control of
the bidder's shareholders alone.
Q
Hybrids
An acquisition can involve a cash and debt combination,
or a combination of cash and stock of the purchasing
entity, or just stock. The Sears-Kmart acquisition is an
example of a cash deal.
Sell Offs
-
A sell off is a disinvestment technique wherein a part
of the organisation (such as a division or a product
line) may be sold to a third party as a process of
strategic planning. A firm may take such a decision to
concentrate on its core business activities by selling
non-core business. A sell off may be desirable:
-
1) To improve the liquidity position
-
2)To reduce business risk by selling high risk activities
-
3)To concentrate on core business areas
-
4)To increase efficiency and profitability
-
5)To protect the firm from hostile takeovers etc.
03/04/10 01:22 AM
03/04/10 01:22 AM
-
N
otes:

A sell-off may occur for many reasons. For
example, if a company issues a disappointing
earnings report, it can spark a sell-off of that
company's stock. Sell-offs also can occur more
broadly. For example, when oil prices surge, this
often sparks a sell-off in the broad market (say,
the S&P 500) due to increased fear .
TAKEOVER
¤
Takeover means the acquisition of control of
shares in one company by another company or
person or group of related companies or persons.
¤
A Company is said to be taken over when
acquiring company or the person is able to
nominate the majority of members on the BOD of
the company being acquired, on account of the
voting power they command at the shareholders
meeting.
03/04/10 01:22 AM
Methods of Takeover
Q
Friendly Takeover –Firstly a person or a
company intending to takeover another
corporation can approach the existing
controlling interest of that corporation ,for
across the board negotiations and purchase.
Q
This form of purchase of shares is generally
referred to as consent takeovers or friendly
takeovers.
03/04/10 01:22 AM
03/04/10 01:22 AM
¤
Hostile Takeovers –The second way is that of a person
seeking control over a company, purchases the required
number of shares from non- controlling shareholders in
the open market.
¤
This method normally involves purchasing of small
holdings of small shareholders over a period of time at
various places. As a strategy the purchaser keeps his
identity a secret. This kind of takeovers are usually
referred to as a hostile or violent takeovers .
Reasons/Benefits Of
Mergers etc.
¤
Economies of scale
¤
Economies of scope
¤
Economies of vertical integration
¤
Complementary resources
¤
Tax shields
¤
Utilisation of surplus funds
¤
Managerial effectiveness
¤
Eliminating/Minimising inefficiencies
¤
Industry consolidation
03/04/10 01:22 AM
03/04/10 01:22 AM

Some dubious reasons for mergers:
1) Diversification
2)Lower financing costs
3)Increasing earnings per share
Factors affecting mergers
03/04/10 01:22 AM
Economic Value Added
¤
Economic Value Added (EVA) is often defined as the value of an
activity that is left over after subtracting from it the cost of
executing that activity and the cost of having lost the opportunity of
investing consumed resources in an alternative activity.
¤
Peter Drucker has described Economic value added as “ A vital
measure of total factor productivity, one that reflects all the
dimension by which management can increase values.”
¤
The underlying concept was first introduced by Eugen
Schmalenbach, and the current theory was formulated by Joel M.
Stern.
03/04/10 01:22 AM
03/04/10 01:22 AM
¤
EVA has been described as the unique
measure, which acts as a basis of all financial
management decisions.
¤
Proponents of EVA say that it is a miracle that
rejuvenates a company from top to bottom.
¤
EVA is said to be the panacea that improves
corporate governance, makes manager’s
think, act and get paid like owners and re-
engineers the financial management system
to measure and reward value creating
activities.
03/04/10 01:22 AM
¤
In order to achieve the goal of wealth
maximisation, a financial manger has the
important function of creating economic value
of the organization.
¤
EVA is a financial tool, which provides to the
organization, knowledge of how much value
the company is adding above the total cost of
capital. It is also a performance measurement
that accounts for changes in share values.
03/04/10 01:22 AM
¤
EVA makes managers act like share
holders. It will provide the company after
tax profits from operations minus the cost
of all capital employed to produce those
profits.
¤
If the finance manager uses EVA it will help
all corporate decisions. It brings about
financial discipline in the company. It will
harmonize decisions to maximize the
wealth of the firm.
Calculating EVA
¤
In the field of corporate finance, economic value added is a
way to determine the value created, above the required
return, for the shareholders of a company.
¤
EVA=Net operating profit after tax- Cost of
funds employed.
¤
If the business earns more than the cost of
funds employed, it denotes the creation of
shareholders wealth and the business has
added value and vice versa.
03/04/10 01:22 AM
Market Value Added
¤
In terms of market and book values
shareholders investment, market value added
may be defined as the excess of market value
over book value. It is also called shareholders
value creation (SVC).
¤
Does higher growth and accounting
profitability lead to increased value to
shareholders? Modern financial management
posits that a firm must seek to maximize the
shareholders value.
03/04/10 01:22 AM
03/04/10 01:22 AM
¤
Market value of the firm’s shares is a
measurement of the shareholders wealth. It is
the shareholders’ appraisal of the firm’s
efficiency in employing their capital. The
capital contributed by shareholders is
reflected by the book value of the firm’s
shares.
¤
Market Value Added=Market value-
Invested capital
03/04/10 01:22 AM
¤
Invested capital or capital employed is the
amount of equity capital and debt capital
supplied by the firm’s shareholders and debt-
holders to finance assets. The firm is said to
have created value if MVA is positive; i.e. the
firm’s MV is in excess of IC or CE.
¤
There is conceptual problem with MVA.
Considering the alternative opportunities of
equivalent risk, the economic value of invested
capital would be much higher today.
C A P M
¤
The capital asset pricing model is a model
that provides a framework to determine the
required rate of return on an asset and
indicates the relationship between return and
risk of an asset.
¤
The required rate of return specified by CAPM
helps in valuing an asset.
¤
One can also compare the expected
(estimated) rate of return on an asset with its
required rate of return and determine whether
the asset is fairly valued.
03/04/10 01:22 AM
03/04/10 01:22 AM

-
The concepts of risk and return under CAPM have
intuitive appeal and they are quite simple to
understand. Financial managers use these
concepts in a number of financial decision-
making processes such as valuation of
securities, cost of capital measurement and
investment risk analysis etc. In spite of all this
CAPM suffers from some practical problems:
1) It is based on unrealistic assumptions.(see next
slide)
2)It is difficult to test the validity of CAPM.
3)Betas do not remain stable over time.
Assumptions of CAMP
*Market efficiency-It implies that share price reflects all available
information.
*Risk aversion and mean- variance optimization-Investors are
risk averse
*Return and risk is evaluated in terms of variance and standard
deviation.
*They prefer highest expectations for a given level of risk.
*Homogenous expectation –All investors have same
expectations about the expected returns and risks of the
securities.
*Single time period- All investors’ decisions are based on a
Single time period.
*Risk free rate - All investors can lend and borrow at a Risk free
rate of interest.
03/04/10 01:22 AM
03/04/10 01:22 AM
CAPM is based on a number of assumptions.
Given these assumption, it provides a logical
framework for measuring risk and linking risk
and return.

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